Thinking of Buying a High-Tech Start-up? Read This First

It is a familiar tale, especially in the volatile world of high technology. Managers in large, established firms look worriedly at the pace and variety of innovation in their industry and wonder how – if at all – they can keep up relying on internal R&D alone. In a garage a few streets away, a few creative geeks come together to start a company aimed at exploiting a new market niche. Fueled by entrepreneurial passion, long hours and coffee, the upstart firm sets a heady pace – and following some initial success, it gets an acquisition offer from a giant company in its industry.

Negotiations ensue. Offers and counter-offers are weighed. A deal is struck, and glowing press releases are issued. Six months or a year later, the most innovative people from the former start-up head for the door, leaving behind the husk of a once-thriving enterprise. All that is left is a disappointed debate over what went wrong.

Can companies avoid this scenario? Indeed they can, according to Phanish Puranam, a doctoral student at Wharton and soon to be faculty member at London Business School, who is studying mergers and acquisitions in high-tech industries with Harbir Singh, chair of Wharton s management department and Maurizio Zollo, who teaches management strategy at INSEAD.

Puranam, Singh and Zollo recently completed the first phase of a study exploring acquisitions by companies such as Cisco, Intel, Sun Microsystems and Hewlett-Packard. Their research shows that if high-tech companies want to succeed in their acquisition strategy, they must know what to change and not change after buying a start-up. “All integration decisions involve costs,” says Puranam. “Non-integration, too, however, involves costs. Successful acquirers must know how to manage both kinds of costs.”

Puranam says the starting point is to recognize that acquisitions in the high-tech industry differ from those in other industries. “The single most important difference is that technology acquisitions are not about cost cutting,” he notes. “Most traditional mergers and acquisitions are about gaining static efficiencies – you buy a company to make it work better. Technology mergers are about dynamic efficiencies. You don t ask how the acquisition will lower costs and improve your bottom line today; you ask how it will affect your ability to introduce new product lines that will improve your bottom line two or three years into the future.” This is because in many high tech industries, innovations multiply over time. In other words, the software giant that buys a small start-up to gain access to a new product wants not just its current version, but also future ones. Acquirers usually buy innovation streams, not just one-shot innovations.

If this is true, it implies that managers need to handle high-tech mergers differently than they do those in other industries. One key variation: “Unlike a traditional merger where you take over a company and then fire people to lower costs, here the whole objective is to keep the product development teams intact,” says Puranam. “In fact, you ve bought the company because of its product development teams, and you ve got to preserve their ability to be innovative.”

How can that be done? That, explains Puranam, is where things get complicated. “Small firms don t work the same way that big ones do,” he says. “An important difference involves the relationship between people s efforts and rewards.” In a small company, an average person s work has a greater impact on the organization s performance than it would in a company with 30,000 employees. Small firms are able to nurture innovation because creative people get payoffs for their contributions, which are more visible. Once a large company takes over a small one, it risks disrupting this process. “Another difference involves the way in which people interact and communicate with one another in small organizations,” says Puranam. “Smaller size and the absence of a strong hierarchy give start-up firms a unique culture and unique patterns of information flows, which might be essential to their innovativeness. The trick is to know what to change in the small firm and what not to change after the acquisition.”

Cisco Systems, the Silicon Valley networking giant, has taken over some 70 small companies in recent years – and Puranam believes it has dealt with these issues better than most other high-tech behemoths. Puranam explains that when Cisco takes over a small company, it changes some things very rapidly. For example, it integrates the information-technology systems of the acquired firm into its own IT infrastructure. What it does not change, however, is the integrity of the R&D team. “It s unclear whether Cisco did this by design or by accident, but this has worked very well for Cisco,” he says.

Cisco typically begins the integration process by taking apart the target firm: Technical units like the R&D team and the product management group are separated from support services such as sales and manufacturing. The latter are often redundant after the merger, since what Cisco brings to the table in any deal is its manufacturing and distribution capabilities as well as its reputation. Therefore, these activities get fully integrated into Cisco s corresponding functions. The R&D and product management teams, however, represent the heart of the small firm and the primary source of its value to Cisco. These groups are allowed to function as a quasi-autonomous business unit. In other words, the goose that lays the golden eggs doesn t get the ax; it gets its own nest.

“If we think about the extent of integration after an acquisition as the extent to which the target firm (or its sub-units) retain a distinctive administrative identity after acquisition, Cisco s approach may be described as one of low integration towards the R&D and product management groups and high integration for the rest of the firm,” explains Puranam.

Other high-tech companies are increasingly beginning to follow this approach in their acquisitions. “With such an approach, if you were to speak to the product development team from a small firm after it has been acquired and ask its members what had changed for them after the acquisition, the answer is likely to be,  Not much, ” says Puranam. “Most engineers continue to work with the same teammates, report to the same technical boss, and work on the same projects.” This approach minimizes the disruption to the team. Often, the team s high-powered incentives are preserved by linking the members bonuses to team performance. Of course, it also helps if the stock options paid out are written on stocks that are shooting through the roof, as they were for Cisco until recently.

These steps allow acquirers to retain engineers from the target firm s product development teams, and even more importantly, to keep them productive. “I ve looked at data showing new patents granted to engineers after Cisco has acquired their company,” says Puranam. “This was part of our research that looked at the post-acquisition patenting behavior of inventors in target firms, and involved some 150 acquisitions by about 40 acquirers. Cisco was head and shoulders above other companies in terms of its performance along this dimension.”

Cisco may have been able to use such an approach consistently because for the most part the company was buying stand-alone products to fill out its product portfolio. As long as the products developed by the target firm s teams were compatible with the rest of Cisco s product offerings and conformed to Cisco s design-for-manufacture process, there may have been little need to interfere with them. Puranam warns that such a hands-off approach may be less suitable when the R&D teams of the acquiring firm and the target firm are required to work very closely. In such cases, the benefits from integration may outweigh the disruption and incentive power loss.

High-tech acquirers that are less successful than Cisco in retaining creative expertise after a merger tend to err in two ways. “Mistakes are made at two ends of the spectrum,” Puranam points out. “The first is doing no integration at all. You buy a company and keep it completely autonomous.” This might initially seem to be a good idea. It certainly is popular among people from the target company, since they do not feel pressured by the acquiring organization. “The question to ask is, why did the large company acquire the small one if it did not mean to touch it at all,” says Puranam. “Why couldn t it have entered into an alliance or a joint venture or even bought a minority stake? What is the point in paying more money and taking on more risk by acquiring the company if you do not intend to extract value?”

The second error is to aim at complete integration and blend the small firm seamlessly with the large one. This, also, might initially seem to work because it allows the acquiring company to eliminate redundancies and avoid problems that arise from having to manage administrative diversity. “But over time you realize that the very things that made the small firm valuable  especially its innovativeness  have gone,” says Puranam. “Of course, while we can point out that generic advice to “integrate fully” or “keep your hands off” are both incorrect, and that intermediate levels of integration may often be appropriate, what needs to be done in a given acquisition depends on the specifics of the deal.”

It is also true that in cases where the R&D team leaves after a takeover, the reason may not always be disruption and loss in incentive power. A key factor may be that the top management team in the small firm, which often owns a significant amount of stock in their firm, may want to cash out and so no longer have an incentive to stay around and be productive. Puranam argues that the first step towards solving this problem is to ask if the acquirer wants the top management team to stay after the acquisition. “Sometimes you may want both the top management team and the engineers; at other times, you may want just the engineers and not the top management team,” he says.

What the acquiring company does depends on its goals for the acquisition. “If your goal is to create completely new product lines in the future, then you should hang on to the entrepreneurs and the top management team,” says Puranam. “These people will help you make it happen.” Companies like Sun Microsystems and Intel are trying to do this by turning founders of companies they have acquired into so-called intrapreneurs or entrepreneurs in residence. “Large companies have an internal corporate ventures unit. Entrepreneurs and their top managers are recognized as people who are good at championing and developing new ideas. They may not be as good at managing day-to-day operations. So you might want to move them into the corporate ventures unit where they continue to develop new ventures.”

In contrast, if the large company s goal for the merger is to acquire just one new product and the ability to make successive innovations on that product alone, it does not need the entrepreneur or top managers. When Microsoft in January 1996 bought Vermeer Technologies, the Massachussetts-based firm that developed FrontPage, the popular web-page authoring software, it took this approach. “Vermeer s top management left within a year, but Microsoft did not mind because it was interested mainly in the software developers,” says Puranam. “Microsoft made one big change; it moved everyone to Seattle. This is standard policy at Microsoft  because it believes that monitoring and information sharing across groups are easier when everyone is in the same location. But after the Vermeer engineers went to Seattle, Microsoft let them work in their old teams and made no attempt to split them up.” FrontPage has remained a successful application under Microsoft s mantle, Puranam adds.

Puranam says that his research with Singh and Zollo points to three overall conclusions:

  1. All integration decisions involve tradeoffs. If an acquiring company integrates the target company too little or too much into its existing structure, it will lose value. Finding the right balance is therefore crucial.
  2. All integration decisions involve costs. Integration efforts take up managerial time, and where layoffs are involved, they also involve severance and other costs. While this is usually understood, an issue that is often overlooked is that non-integration also involves costs. “You can get a demotivating effect if employees in the acquiring firm begin to question their value because their counterparts in the target firm are treated differently (and perhaps better),” says Puranam. “Such non-integration costs are hard to capture on a balance sheet, but they are real and hurt productivity.”
  3. Successful high-tech acquirers have capabilities that let them cut both integration and non-integration costs. Reducing integration costs is often a matter of experience. Companies that do a lot of acquisitions and keep learning from the process  as Hewlett Packard or Intel have done  are able to streamline their acquisition capability and become very good at it. Among financial firms, Bank One has gained lots of expertise at mergers not only by doing several of them, but also by putting in place a process to capture and codify the knowledge obtained through these experiences.

Non-integration costs, though, are rarely under managerial control. These have much more to do with an organization s history and culture. “If you are a large decentralized firm with great diversity in pay and benefits, if you acquire a small company and maintain it on a different incentive scheme no one may care. That is the norm in your firm,” says Puranam. “On the other hand, if you have fairly homogeneous pay, benefits and autonomy for a given level across the organization, if you acquire a firm whose people are then treated differently than the rest, the word will get around. This is rarely something that individual decision makers can control when they are looking at an acquisition.”

This last factor, notes Puranam, points to an interesting result. Over integration is often blamed when people from an acquired start-up leave, but the critics may not realize that the company is simply trying to avoid non-integration costs. “The executives in the big company aren t crazy,” he says. “This may just be the cost of doing business in their industry. Not integrating the start-up into its larger organization may be more expensive than integrating it.” Understanding this tradeoff may help save much heartache later for both people in the target firm and those who are acquiring it.

To learn more about this research and participate in a benchmarking survey on high-tech acquisitions, click here.

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